2 Ways to Adjust to Beaten-Down Utilities

by Tyler Craig | May 29, 2013 12:55 pm

The entrance of the equities market into correction mode has not affected all sectors equally. Given the sharp rise in interest rates following last week’s comments from Ben Bernanke that the Fed could pare back its QE program later this year, rate-sensitive sectors like utilities and REITs have been taken behind the woodshed and mercilessly beaten.

Here are a few stats to consider:

The 10-year Treasury Yield (TNX[1]) has risen from 1.88% to 2.16% since last Wednesday’s intraday low.

The Utility SPDR (XLU[2]) has fallen from $40.54 to $37.85 since last Wednesday’s intraday high — a drop of 6.6%.

The Vanguard REIT ETF (VNQ[3]) has fallen from $78.86 to $72.82 since last Wednesday’s intraday high — a drop of 7.6%.

What I find particularly interesting is the fact that the utility sector flashed multiple warning signs[4] before this week’s massive free fall. Those who followed the clues were rewarded handsomely for their bearish bets. Given how far utilities have fallen, though, now is not the time for those with bearish positions to rest on their laurels. Instead, consider taking a few defensive actions to lock in gains and otherwise reduce risk.

Let’s explore two potential adjustments you could make if you purchased the July 41 put for $1.40 as suggested in “Utilities Are Running Out of Energy.”[5]

The Roll Down

Click to Enlarge The ongoing drop in XLU has lifted the value of the July 41 put from $1.40 to $3.60, generating an unrealized gain of $2.20. One of the easier adjustments you might consider is rolling down your put to a lower strike price.

For example, you could sell the July 41 put — thereby capturing the $2.20 profit — and buy the July 38 put for $1.10. If XLU continues its downward spiral, you will rack up additional gains with the new put. On the other hand, if XLU rebounds in the coming weeks, you only have $1.10 at risk instead of $3.60.

Rolling to a Put Vertical

An alternate adjustment to consider is rolling your long July 41 put to a put vertical spread by selling a lower-strike put in the same month. For example, you could sell the July 38 put for $1.10, turning your position into a long July 41-38 put vertical. Your new cost basis drops from $1.40 (the cost of the original July 41 put) to 30 cents (the premium paid for 41 put minus premium received for 38 put).

In exchange for drastically reducing the cost basis and therefore risk of the trade, rolling to a put vertical also limits the potential profit to the distance between strikes minus the cost basis, or $2.70. Since the current profit is already $2.20, you can make an additional 50 cents in profit if XLU remains below $38.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.